The following is an excerpt from Jackass Investing: Don't do it. Profit from it. It's a book that takes "conventional knowledge" on investing and argues that it's a myth.
Perhaps one of the most famous anecdotes related to market timing can be attributed to Baron Rothschild. In July 1870, Napoleon III, the nephew of Napoleon Bonaparte, threw France into a war with Prussia. The result was a disastrous for France. In September 1870 the Prussian army began the siege of Paris. After a massive bombardment of the city, on January 28, 1871, Paris surrendered and a new provisional government was formed. During the siege however, hundreds of thousands of Parisians became armed members of a citizen’s militia known as the “National Guard,” which held 400 cannons on the Butte Montmartre. The new government viewed this as a threat and ordered its own troops to seize the cannons. But instead, the government troops rebelled against the order and effectively joined forces with the National Guard. Fearfully, the govern-ment members fled to Versailles, leaving the Central Committee of the National Guard as the only effective government in Paris. In keeping with its democratic ideals, the Central Committee arranged for elections for a “Commune,” which took place on March 26th.
Soon thereafter however, government forces returned from Versailles and besieged the city. Their forces, enlarged by French POWs released by Prussia, pushed back the National Guard. The siege reached its climax during “La Semaine Sanglante,” or “The Bloody Week,” in May 1871, when as many as 30,000 people were reportedly executed or killed in fighting. It was at that time that a young man, who had just received a large inheritance, called on the great banking firm of Rothschild to ask their advice on how best to invest his fortune. Here’s a recounting of the story as published in a 1917 edition of The Gas Record:
In 1871 when the Commune in Paris was at its height and the streets were red with blood, a young man called on the great banking firm of Rothschild to ask advice about a large fortune to which he had become heir. The head of the house told him to buy French Government Securities. “What: buy securities when the streets of Paris are running with blood!” was the young man’s surprised exclamation. Baron Rothschild is re¬ported to have said: “My young friend, that is the very reason that today you can buy securities for 50% of their face value.”
This led to the oft-quoted adage “Buy when there’s blood in the street.” Investment opportunities are presented to you at exactly the time you are least emotionally prepared to accept them. That is precisely why they exist.
Fortunately, investment opportunities do not require actual blood to be spilled. Far less dramatic opportunities are pre¬sented every day. And the world’s greatest investors, in fact “The World’s Greatest Investor,” regularly employs market timing.
“The World’s Greatest Investor” (also known as The Oracle of Omaha)
“The World’s Greatest Investor” (the phrase often used when referring to Warren Buffet), is a market timer. Buffet’s company, Berkshire Hathaway, held $47 billion dollars, a full 28% of its market capitalization, in cash at the U.S. stock market peak in the fall of 2007. This was the most cash ever held by Berkshire Hathaway and turned out to have been a great time to have been in cash, as stock prices fell by more than 50% over the ensuing 18 months. Rather than increasing his stock positions at unattractive prices he engaged in market timing by making the decision to hold a large cash position.
Conversely, as stocks began to collapse during the financial crisis of 2008, Buffet began to buy. First he picked up a distressed position in both Goldman Sachs and General Electric. In late 2009 he capped off his buying spree with a purchase of the remaining shares in Burlington Northern Santa Fe railroad that he didn’t already own. At a price of $44 billion, this was, by far, the largest purchase Buffet’s company had ever made.
Buffet knows and uses what you learned in Myth #1 – Stocks Provide an Intrinsic Return – short-term stock prices are driven primarily by people following their emotional weather vane. When they are depressed about corporate prospects, as they were during the 2008 financial crisis, they drive the prices of stocks straight down.
Warren Buffet is a “value investor” only because people, through their knee-jerk buying and selling patterns, consistently provide him with the perfect opportunity to be one.
Perversely, the recognition of this short-term behavior leads to Buffet’s reputation as a long-term investor. Once he’s made his opportunistic purchase, Buffet holds many of his stock posi-tions for long periods of time. He is capturing the benefit of corporate growth, which dominates stock prices over long periods of time. He is hand-picking individual stocks. Not the market. He is interested in reaping the benefits of selecting strong, well-managed companies and being rewarded in higher stock prices for their individual corporate performance.
Stocks aren’t the only financial instrument Warren Buffet market times. As Mr. Buffet succinctly describes in his 2007 letter to shareholders of Berkshire,
The U.S. dollar weakened further in 2007 against major currencies, and it’s no mystery why: Americans are a lot more excited about buying products made elsewhere than the rest of the world is about buying products made in the U.S. Inevitably, that causes America to ship about $2 billion of IOUs and assets daily to the rest of the world. And over time, that puts pressure on the dollar.
And a few paragraphs later he describes a long position he entered into in the Brazilian currency, the “real,” as a way to time the direction of the U.S. dollar:
At Berkshire we held only one direct currency position during 2007. That was in – hold your breath – the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodi¬cally withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth. But any Brazilian who followed this apparently prudent course would have lost half his net worth over the past five years. Here’s the year-by-year record (indexed) of the real versus the dollar from the end of 2002 to year-end 2007: 100; 122; 133; 152; 166; 199. Every year the real went up and the dollar fell. Moreover, during much of this period the Brazilian govern¬ment was actually holding down the value of the real and supporting our currency by buying dollars in the market.
Not only does Mr. Buffet reveal that he is a market timer, but that he is timing a currency which as a market has proven to be the antithesis of buy-and-hold. As he acknowledges, “during the past century five versions of Brazilian currency have, in effect, turned into confetti.” As discussed in Myth #1 – Stocks Provide an Intrinsic Return, and clearly understood by Mr. Buffet, the past performance of a market is virtually irrelevant when considering whether to buy or sell it today. All that mat-ters is whether the return drivers for that market today warrant a buy or sell decision.
“Sure,” you say. “It’s easy for The World’s Greatest Investor to successfully time the market. That’s why he’s The World’s Greatest Investor. But what about me?” The answer is: you can – precisely because most people can’t.
It appears that people are hard-wired for investment failure. Because of that it is easier for financial professionals to instruct their clients to buy-and-hold rather than attempt to time the market, simply because most people will time the market incorrectly. But you don’t have to be one of those people. You can exploit their behavior.